Thursday, August 12, 2010
TIPS (Treasury Inflation Protected Securities, the original acronym) are complex bonds that are difficult to evaluate. I first recommended TIPS in October 2008 ("TIPS are a steal"), and pounded the table to buy them for the next several months. I have been consistently a fan of TIPS (though more recently only for as a substitute for cash) ever since. If you take TIP as a proxy for the TIPS market, TIPS have enjoyed price appreciation of some 18% since their low in November '08, plus interest (in the form of their real coupon) of about 5%, for a total return of roughly 24%. That's not as good as equities, but then TIPS are default-free bonds that pay guaranteed interest while equities are full of risk.
As the chart above shows, the real yield on TIPS is now as low as it's ever been, which means that TIPS prices are at or near their all-time highs (the market price of TIPS varies inversely to their real yield). As my chart also suggests, TIPS are in "expensive" territory based on their real yield. Is now the time to sell?
If you are trader holding TIPS and not particularly concerned about the future of inflation or downside risk to the economy, then now is an excellent time to sell TIPS. Real yields might fall a bit further, but I think they are reaching their limit. Real yields are low because nominal yields are low, and both are low because the market is terribly concerned about the risk of a significant slowdown in the U.S. economy. Low Treasury and TIPS yields are a direct reflection of a deep pessimism that pervades both the stock and the bond markets. I don't share the market's pessimism, so I'm willing to think that the decline in yields has just about run its course.
If you are a long-term investor holding TIPS, then you should understand that TIPS are quite unlikely to enjoy any price appreciation from here. TIPS returns will be driven entirely by the change in the CPI going forward, and the risk of some price depreciation in the future is not negligible. As the next chart shows, TIPS are priced (relative to Treasuries) to the assumption that the CPI is going to rise 1.8% per year on average for the foreseeable future. (That's the breakeven or expected inflation rate.) Thus, the market is saying that a TIPS holder is likely to earn 1.8% per year from inflation, plus a 1% coupon, for a total return of 2.8% per year, minus any price depreciation that happens to occur.
That's not a particularly exciting prospect. TIPS are going to deliver exciting returns ONLY if inflation turns out to be significantly higher than the market expects, and they could deliver disappointing returns if inflation doesn't change much, if real yields rise because TIPS fall out of favor, and/or the economy picks up and Treasury yields in general rise.
So TIPS are now a pure bet on inflation. Inflation has to pick up meaningfully for an investment in TIPS to do better than Treasury bonds. If it doesn't, you're going to either make a pittance or you're going to lose some money.
I could say the same thing about gold, however, but in spades. Consider that gold has soared 370% since its early 2001 low (next chart). If gold is up because central banks all over the world are in accommodation mode, then gold is anticipating lots of inflation down the road. If you buy gold today, you NEED lots of inflation to show up, and you NEED central banks to remain super-accommodative, otherwise gold could collapse. If gold is up because of geopolitical risks or other types of raw fear, then you NEED things to never get better, otherwise gold could collapse.
TIPS and gold are two classic inflation hedges, but with very different characteristics. Gold is like a highly leveraged play on inflation, but TIPS have limited downside risk. Gold might drop by 60% or more. But TIPS have no default risk and, more importantly, the real yield on TIPS almost certainly has an upper limit (unlike the yield on nominal bonds, which can theoretically rise without limit). I say that because the real yield on TIPS is a U.S. government-guaranteed real yield—a risk-free real yield. At the end of the day, the only yield or return on an investment that really counts is its real (after-inflation) yield. If you could buy TIPS with a real yield of, say, 4% or more, would there be any investment in the world that could match that on a risk/reward basis? I seriously doubt it. If real yields on TIPS rise, at some point they will become absolutely compelling investments relative to the universe of other investments, and my guess is that the upper limit is around 4%.
If real yields were to rise from 1% to 4%, this would equate to a drop in price for TIP of 20-25%; that would be offset by their 1% real coupon plus whatever inflation happens to be. Thus, the downside risk to TIPS in a worst-case scenario (barring a U.S. government default, in which case all bets are off) would be a mark-to-market loss of 20-25% that could be reduced if one were willing to hold TIPS to maturity. (TIPS traded briefly above the 4% yield level in 2001, but that was when the TIPS market was still in its infancy, they were not well understood, and equities were all the rage because people thought the economy would grow 4-5% per year forever.)
To summarize: TIPS make sense only for long-term investors who are concerned about the risk of rising inflation and are willing to suffer some losses if that doesn't happen, and TIPS are a much less risky hedge against rising inflation than gold.
Full disclosure: I am still long TIP and TIPS at the time of this writing.
Posted by Scott Grannis at 11:34 AM